Bull by the Horns

by Sheila Bair

  At the end of the day, we can pass all the laws and write all the rules that we want, but if we don’t have good-quality people interpreting and enforcing them, our efforts at reform are destined to fail. Too often, media scrutiny and public interest are focused on the legislative battles and high-profile rule writings and not enough on the nuts and bolts of enforcing the rules. We have a number of good people in government, and we need to recruit more. Better policies to promote independence of judgment and breadth of perspective among career staff are essential if financial reform efforts are to succeed.

  Reform the Senate Confirmation Process

  By statute, the heads of all of the major financial regulatory agencies are appointed by the president and confirmed by the Senate. When the president and Senate are unable to agree on a nominee to head an agency, an acting head is named. As I write this in mid-2012, three of the seven major financial agencies do not have Senate-confirmed heads: the FDIC, the FHFA (the GSE regulator), and the CFPB. In addition, the Office of Financial Research—which was created by Dodd-Frank for the important task of centrally collecting and analyzing financial data to identify systemic issues before they become problems—does not have a Senate-confirmed head.

  Responsibility for this rests with both the president and the Senate. Amazingly, notwithstanding the role of the GSEs in contributing to the financial crisis, it was not until late 2010 that President Obama submitted to the Senate a nominee to head FHFA. Similarly, notwithstanding the importance of ensuring effective supervision of the nation’s big national banks, it was not until 2011 that he submitted his own nominee to take charge of the OCC.

  But the Senate has not behaved well either. It inexplicably blocked a Nobel laureate to serve on the Federal Reserve Board and a well-regarded state bank supervisor to head the FHFA. Well-qualified nominees to head the FDIC and OCC and to serve on the FDIC and Federal Reserve boards have had their confirmations held up for months. It is very difficult for the leadership of those agencies to function with Senate confirmations hanging over their heads. Every decision, of course, ends up being weighed against whether it will antagonize anyone in the Senate. Under Senate rules, a single senator can hold up a nomination for months.

  Financial regulators are not the only ones who have been held hostage to the Senate’s confirmation processes. Virtually all other agencies of government have had their leadership held up at one time or another because of the vagaries of Senate rules. Judicial vacancies can languish for months or years as senators wrangle over whether to confirm nominees. Typically, the delay has nothing to do with the candidate. Rather, senators use nominations as leverage. For instance, when I was nominated to serve in the Bush Treasury Department in 2001, my nomination was quickly confirmed by the Senate, but the nominations of several of my Treasury colleagues were held up for months by a member of President Bush’s own party, Republican Senator Jesse Helms of North Carolina. Helms had no objections to any of the nominees; rather, he wanted the Treasury Department to change one of its trade policies related to textile imports.

  Regardless of which party is in control of the Senate, nominations are frequently held up to extract concessions from the administration. Indeed, the current Senate leadership has been known to call them “high-value targets.” The unpredictable nature of the Senate confirmation process deters good people from entering government service. We want administrations to draw from Main Street talent throughout the country in recruiting people to accept senior government jobs. Yet what person in his or her right mind would willingly submit to a highly public and unpredictable Senate confirmation process, with no certainty about when he or she will be able to start the new jobs? Moving to Washington is a huge undertaking for the average Main Street American. You have to sell or rent your house, find a new house, find new schools for your kids, and if your spouse works outside of the home, he or she will want to find a new job. To undertake a career opportunity that risks being held up for months or longer is a burden many qualified individuals and their families are unable to accept.

  Nominees should be guaranteed an up-or-down vote on their confirmations once the Senate committee with jurisdiction has approved their nomination. Senate committees have functioned pretty well in processing nominations; the holdups have really occurred on the Senate floor. The occasional unqualified candidate can be screened out in the committee. But once the committee has acted, the nominee should have an up-or-down vote within thirty days. If we want high-quality people of integrity to serve in government, we need to treat them with courtesy and respect, not as potential hostages in a high-stakes game of political cat and mouse. The Senate needs to reform the confirmation process. Otherwise, the only people left willing to take those jobs will be politically connected Washington lobbyists.

  THINGS THAT WILL MAKE THE ENTIRE FINANCIAL SYSTEM WORK BETTER

  Abolish the GSEs

  One of the most intense controversies of the 2008 financial crisis surrounds the role of Fannie Mae and Freddie Mac, otherwise known as the government-sponsored enterprises (GSEs). Defenders of Wall Street try to put the bulk of the blame on them, suggesting that they caused the crisis in an effort to fulfill government mandates to back mortgages to lower-income families. Critics of Wall Street and GSE supporters argue that the lion’s share of the toxic loans was originated and funded through Wall Street securitizations and that the GSEs consistently maintained higher lending standards for their securitizations than Wall Street did.

  As is the case with most controversies, the truth lies in the middle. Wall Street did fund most of the toxic mortgages, and the GSEs did maintain higher lending standards for the mortgages they securitized and backed. Nonetheless, the GSEs did contribute to the crisis, and here’s how: since bond investors viewed Fannie Mae and Freddie Mac as implicitly government-backed, the GSEs were able to raise money by issuing debt at very cheap rates. They would then take the cheap money and buy much-higher-yielding Wall Street mortgage-backed securities, that is, securities that were backed by all of those toxic subprime and nontraditional loans. In that way, the GSEs operated like huge hedge funds, reaping substantial profits for their executives and shareholders based on the spread between the interest they paid on their debt and the much higher returns they received on Wall Street securitizations. Of course, if the mortgages backing those securities went bad, the onus would be on the taxpayer. That is what happened. When the housing market started to deteriorate, Fannie and Freddie lost money quickly. Since they had very low capital requirements, they had little capacity to absorb losses on those Wall Street securities.

  The debate over Fannie and Freddie ignores the symbiotic relationship between the financial sector and the GSEs. It is not a case of one being culpable and the other innocent. Both are to blame. Since Fannie and Freddie283 were taken over by the government in 2008, taxpayers have plowed $180 billion into them to keep them operational. The $180 billion is another indirect bailout of the financial sector. Fannie and Freddie acquire loans from banks, securitize them, and then sell the securities to investors. Importantly, the GSEs guarantee investors against any losses. The biggest sellers of loans to the GSEs are, of course, the big banks.

  The GSEs perform a very valuable service for them and other banks, particularly since there is no longer a private securitization market. Most banks do not want to keep low-interest-rate thirty-year mortgages on their books, and many are still worried about default risk, given the continued weakness of the housing market and economy. Fannie and Freddie take both the interest rate risk and the credit risk on these mortgages off the banks’ hands. To be sure, their support makes it easier for households to obtain mortgages at reduced cost. But Fannie and Freddie are not charging banks enough money to cover their costs. That is why, quarter after quarter, taxpayers have had to infuse more money into them. By not charging the banks high enough fees to cover their costs, Fannie and Freddie are providing yet another indirect taxpayer bailout.

  In the short term, Fannie and Freddie
should immediately increase the fees they charge banks to end the need for continued taxpayer subsidies.

  Ultimately, both institutions need to be liquidated. My personal view is that we do too much to subsidize the housing market already. We should let the private markets decide how much capital to allocate to mortgages. The generous government guarantees and tax subsidies we give to housing finance have skewed needed public and private investment away from other sectors such as manufacturing, technology, and physical infrastructure.

  But if we decide to maintain a government role in buying and guaranteeing mortgages from banks and other mortgage lenders, let’s at least do it honestly, through a government agency such as the FDIC. The costs of the guarantees should be accounted for in the federal budget, and the agency should charge sufficient premiums to cover projected losses in advance, as does the FDIC. The hybrid nature of Fannie and Freddie led to disastrous consequences. Taxpayers implicitly backed them, while executives and shareholders reaped huge private benefits. Those too-big-to-fail institutions took excessive risks on high-flying Wall Street investments, and bondholders lent them money to do it, relying on government bailouts if things went bad. And because their bet proved to be right, all their instincts would be to do it again.

  Stop Subsidizing Leverage Through the Tax Code

  When most people think about the causes of the financial crisis, they think of greed and regulatory failures. Though those were certainly driving factors, the tax code also played a role.

  For instance, under current law, interest paid on debt is fully deductible, while dividends paid to shareholders are not. This is one of the reasons why it is cheaper for a financial institution to fund itself with debt than equity. Prior to the crisis, financial institutions lobbied regulators relentlessly to let them finance more of their operations with borrowed money and treat tax-deductible hybrid instruments as capital. Unfortunately, the Fed and SEC succumbed to some of those pressures, with the result that many large financial institutions had too little real-equity capital to absorb losses when the crisis hit.

  The tax code also gives home owners every incentive to borrow to the hilt. A dirty little secret of the crisis is that the majority of toxic mortgages were not made to expand home ownership; they were refinancings aggressively marketed to home owners as a tax-advantaged way to pull cash out of their homes. (The biggest tragedy is that many long-standing home owners with safe thirty-year fixed-rate mortgages refinanced into toxic mortgages and ended up losing their homes.) For most home owners, interest on their mortgage is fully tax deductible, while interest on a credit card or other consumer loan is not. So they treated their house like a credit card. With an overheated housing market providing artificial gains in home prices, home owners could pull that cash out tax free and deduct the interest on their new, bigger mortgage to boot.

  Hopefully, after the presidential elections, Congress and the administration will tackle meaningful tax reform. In doing so, they should end these subsidies, which encourage excessive, destabilizing leverage. For instance, we could homogenize the treatment of debt and equity in a way that would be revenue neutral by allowing corporations, including banks, to deduct some portion of both interest and dividends.

  We should also recognize that there is a difference between promoting home ownership and promoting home finance. Canada has no mortgage interest deduction, yet it has a comparable rate of home ownership and fewer leveraged home owners. My first preference would be to get rid of the mortgage interest deduction and use the $100 billion in savings to reduce tax rates and pay down the national debt, while providing some transition time in fairness to those who bought their home in reliance on the deduction. A simpler tax code with lower rates would spur economic growth and additional tax revenue. But if we want to use the tax code to promote home ownership instead of subsidizing interest on debt, perhaps we should give home owners a tax credit based on how much of their original mortgage principal they pay down each year. The credit could also be extended to a down payment up to a certain cap, say $5,000. Such a credit could stimulate housing demand while providing incentives for home owners to build equity in their homes.

  It used to be that the American dream of owning a home was a means to wealth accumulation, with families building substantial equity through regular payments on their mortgages over a period of years. Building that equity was a source of pride. The equity was used to support home owners in their retirement years, when empty nesters sold their homes for smaller living quarters. Or they passed their mortgage-free houses on to their kids after they died. That old-fashioned model of home ownership worked for decades. Any tax code incentives should be geared toward equity accumulation, not wealth-stripping serial refinancings.

  Tax Earned Income and Investment Income at the Same Rate

  One of the reasons Wall Street firms found it so easy to find gullible investors to buy their toxic mortgage-backed securities was that there were just too many investment dollars searching for returns. That was in part due to the Federal Reserve Board’s years of easy monetary policy. But the tax code also provides incentives to seek income through investment instead of work.

  Under our tax code, if you work for a living, your tax rate goes as high as 35 percent, but if your earnings come from capital gains or dividends, you have to give up only 15 percent to Uncle Sam. The rationale for this $90-billion-a-year tax benefit is that it spurs job-producing investments, though there is little credible economic evidence that this is the case. Equally likely is that it contributes to a glut of investment dollars searching for return, with too few opportunities for productive use in the “real” economy. So we create incentives for financial institutions to come up with an endless array of complex, structured financial products to meet investors’ insatiable demand for return. Just how many jobs did all of those CDO-squared’s give us anyway?

  And for those (like me) who bemoan the fact that too many of our best and brightest are drawn to the financial services sector, what kind of message does the tax code send? Go get a job and find the cure for cancer, we will tax you at 35 percent. But go manage a hedge fund, and you will have to pay us only 15 percent.

  We should tax labor and investment income at the same rate. As Warren Buffett has pointed out284, if there is a profit to be made, investors will come. Whether they are taxed at 35 percent or 15 percent, they will still make a profit. I do not like the administration’s proposed “millionaires’ tax” because it adds to the complexity of the tax code and casts the issue as rich versus poor. The issue really to me is labor versus investment. We value both and should tax both at the same rate. Here again, the savings could be used to reduce everyone’s rates and pay down the national debt.

  Reduce the National Debt

  The 2008 financial crisis began on Wall Street, where misguided bets on risky mortgages resulted in enormous damage to both our financial system and our economy. However, I fear that the next financial crisis, if we have one, will start not in New York but in Washington.

  The annual federal deficit has grown from $161 billion in 2007 to $1.3 trillion in 2011. Each year, this deficit is paid for through increased Treasury borrowing. Our national debt has nearly doubled since 2007 and currently exceeds $15 trillion, or about $50,000 for every man, woman, and child in the United States. This explosive growth in federal borrowing was heavily driven by the financial crisis and the deep recession it caused. Tax revenues plummeted while the Obama administration and Congress authorized trillions of dollars in stimulus spending to try to counteract the economic damage. Unfortunately, much of the stimulus spending was designed to create short-term increases in consumer spending, without any long-term benefit.

  The deficits are also attributable to the government’s continued unwillingness to make the hard choices necessary to rein in our long-term structural deficits. Our two biggest entitlement programs, Social Security and Medicare, are both on a path to insolvency. Medicare will exhaust its reserves by 2024, and Social Securit
y will run out its reserves by 2033. The politically popular, though fiscally foolish, payroll tax cuts cost the already wobbly Social Security system $105 billion in 2011 alone. Those retiring today will see their benefits cut short. For our kids and grandkids, there will be nothing.

  Unsustainable budget deficits285 will not only create shortfalls in promised federal benefit programs but will also provide the catalyst for a financial crisis of the same if not greater magnitude than the one we saw in 2008. Our political system has repeatedly demonstrated an inability to deal with our fiscal problems. The country has already suffered the embarrassment of losing its triple-A credit rating. Those who discount the importance of the burgeoning national debt point to the fact that the U.S. Treasury can still borrow money at very low rates. This is true, but the Fed is printing money to buy a large percentage of the debt. In February 2012286, the Fed held more than $1.6 trillion in U.S. Treasury bonds, triple its holdings of a year before. Another artificial factor stimulating investors’ demand for U.S. debt is the lack of alternatives. Because of Europe’s problems, investors there are limited in their choices of finding safe government-backed securities. In other words, interest rates on U.S. debt remain low because we are the best-looking horse in the glue factory.

  Eventually Europe will solve its problems, or another country’s debt may unexpectedly emerge as a more attractive investment than U.S. Treasury obligations. Understanding that our budget deficits and national debt are on an unsustainable path, bond investors will put their money elsewhere. The fundamentals of our fiscal health do not support the low interest rates bond investors are now paying. Just as the poor credit quality of securitized mortgages did not support the high values assigned to mortgage-backed securities before the crisis, the poor credit quality of our overleveraged government does not support low U.S. bond yields.